A Million Bucks Ain't What It Used to Be

Don't get starry-eyed at the results of some online calculators.

You work hard as an investor. You look at ridiculous amounts of information, ranging from economic data releases to every scrap of financial figures from your favorite stocks. You use The Motley Fool and other sources to provide analysis of that information, expecting to combine your own insights with those of others to find the best investments available. You've demonstrated an ability to choose high-flying stocks like Google(NASDAQ:GOOG) and Hansen Natural(NASDAQ:HANS). You know that investing is a marathon, not a sprint, so you use a long-term time horizon to evaluate your success.

But that doesn't mean you don't make quick decisions when necessary. Saving is as important as investing, and you do what you can to keep more of every dollar you earn.

In exchange for all that hard work, you expect a big reward: financial security and independence. By making some simple assumptions about your investment returns and how much you'll be able to save every month, you can use any of a huge array of online financial calculators to tell you how far you'll get.

You can be a millionaire...Assume that you're 35 years old and expect to retire at 65. You've scrimped and saved and have managed to find $1,000 to put aside each month toward your retirement. You make smart investments, but you don't want to be overly aggressive, so you assume you'll be able to make 7% on your money over the long term. By using tax-deferred accounts like IRAs and employer-sponsored retirement plans, you don't have to worry about paying taxes along the way.

Using a simple financial calculator, you can determine that your $1,000 monthly contributions plus your investment returns will result in your having over $1.2 million in 2036. Mission accomplished! You'll be a millionaire! You can stop here, right?

...but what will it get you?The problem with stopping there is that it leaves out several very important considerations. Tax deferral doesn't let you avoid taxes forever; it just puts off the day of reckoning until you withdraw money from your retirement accounts. More importantly, rising prices will erode the value of your money, so reaching the million-dollar mark won't give you nearly as much bang for your bucks as you'd get today.

Many people forget to account for the taxes they'll have to pay when they withdraw from their retirement accounts. Keep in mind that all of your withdrawals will be taxed at the rates imposed on ordinary income, currently as much as 35%. Even if you invest your retirement funds in assets that would qualify for special lower tax rates for dividends and capital gains if you held them in a taxable account, you won't be able to use those lower rates for your retirement money. Furthermore, if you withdraw more money from your retirement account to pay the tax, then you'll have to pay tax on that additional withdrawal. This vicious circle significantly increases the total amount you need to withdraw. For instance, if you need $12,000 and pay 25% tax, you may think you'd need to take out an extra $3,000 to pay the tax since $3,000 is 25% of $12,000. But because you have to pay tax on that extra $3,000 withdrawal as well, you actually need to withdraw $4,000 more. Add in any applicable state income tax, and it's easy to see that the IRS can end up with a big chunk of your million.

Even more insidious is the effect of rising prices. Consider that in 1975, the average house cost just more than $50,000, the average car cost about $3,800, gas cost $0.57 per gallon, and you could buy a loaf of bread for $0.30. The median household had income of less than $12,000. With those prices, $1 million would last a long time. Just the interest and dividend income on investments worth $1 million would put you well ahead of the average working family. In contrast, even assuming relatively low inflation of 4% over the next 30 years, it won't be surprising to see $10 milk, $250 fill-ups at the pump, ordinary cars for $100,000 or more, and average prices for houses approaching $1 million. In order to sustain your standard of living, your savings will need to keep pace with increasing costs.

Use the right calculatorIn order to take these factors into consideration, make sure that you're using a financial calculator that allows you to make assumptions about future inflation and taxes. Here at The Motley Fool, you can look at a wide variety of different calculators that include places to input prospective rates of inflation and taxation. By making several different assumptions, you can figure out not only about how much you should be saving, but also how big an impact unexpected changes in tax and inflation rates will have on your long-term goals.

Following up on the earlier example, if you have a retirement account worth $1.2 million in 2036, the purchasing power of that money will be equivalent to less than $400,000 today, and a quarter of that money would potentially be lost to taxation. Put another way, in order to generate enough money to leave you with the same purchasing power after taxes that $1.2 million has today, you would have to save over $4,200 each month and end up with an account balance in excess of $5 million.

Don't lose heartAll of this isn't as bad as it may sound. Although reaching round numbers like $1 million may have special psychological value to you, making that millionth dollar doesn't have any more real significance than making the previous dollar. Making a million is a worthy goal, and for some, it would provide adequate resources for their needs. Before you decide that you've made enough, however, think about what that million will be worth. The odds are that it won't be what it used to be.

For more helpful advice on grappling with the dark forces of taxation and inflation, try a free trial to Rule Your Retirement. Click here for more details.

Fool contributor Dan Caplinger isn't a millionaire yet, but he's hoping he'll be young enough to celebrate in style when the time comes. He doesn't hold positions in any of the companies mentioned in this article. The Fool's disclosure policymakes you feel like a million bucks.

Author

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.
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